The Impact of Clients’ Indirect-Effect Illegal Acts on Auditors’ Market Shares

SUMMARY Existing auditing standards require auditors to detect material illegal acts that directly affect financial statements, but not those with indirect impacts, as these involve operational issues outside their expertise. The Public Company Accounting Oversight Board has proposed amending these standards because the distinction confuses investors, who increasingly expect auditors to identify and report indirect-effect illegal acts. Using regulatory fines to proxy for these acts, we find that the auditors’ market share growth rate remains unaffected by fines on their clients. However, auditors face a reduced market share growth rate if they continue serving fined clients. An explanation for our finding is that, consistent with extant standards, market participants do not expect auditors to be aware of their clients’ indirect-effect illegal acts and do not penalize them for associating with guilty clients. Yet, once a fine is public, the market penalizes auditors who do not distance themselves from the fined clients. Data Availability: Data are available from public sources cited in the text. JEL Classifications: M42; K22; M48.